In the only bankruptcy case pending before it this term,
a unanimous Supreme Court has ruled that the archaic term
"defalcation" used in 11 U.S.C. Sec. 523(a)(4) requires

knowledge of, or gross recklessness in respect to, the
improper nature of the relevant fiduciary behavior

complained of. Bullock v. BankChampaign, No.
11-1518 (5/13/13), Slip Op., p.1, which can be found here. While
the case represents a setback for the creditor in the specific case, the
judicial hairsplitting engaged in by the Court ensures that trial courts will
continue to struggle with the meaning of "defalcation."

What Happened

In 1978, a father established a trust for the benefit of
his five children and named his son Randy as trustee. The trust allowed the
trustee to borrow money against the asset of the trust, which was an insurance
policy. On three occasions, Randy borrowed against the policy to make loans to
himself and his mother. The first loan was made at the father's request. All of
the loans were repaid with interest.

Was the family pleased with Randy's
investing? No. They sued him to recover his profits made on the
investments. Although they alleged that their brother "does not appear to
have had a malicious motive in borrowing funds from the trust" he
"was clearly involved in self-dealing." The state court agreed and ordered
Randy to repay the trust for "the benefits he received from his
breaches" (along with costs and attorney's fees).

When Randy could not pay, he filed bankruptcy. The
replacement trustee for the trust brought suit to except the debt from
discharge under 11 U.S.C. Sec. 523(a)(4). Section 523(a)(4) denies discharge
for debts arising from fraud or defalcation in a fiduciary capacity, larceny
and embezzlement. The Bankruptcy Court granted summary judgment that the debt
was nondischargeable based on defalcation in a fiduciary capacity. The District
Court affirmed. The Court of Appeals affirmed as well, finding that "the
conduct can be characterized as objectively reckless." 670 F.3d at
1166.

The beleaguered Randy asked the Supreme Court to consider
whether "defalcation" applied "in the absence of any specific
finding of ill intent or evidence of an ultimate loss of trust principal." The
Supreme Court agreed to hear the intent issue, but did not consider whether
there could be defalcation in the absence of a loss of principal.

What the Court Ruled

The Supreme Court reversed and remanded the decision of
the Eleventh Circuit. The Court held, as stated above, that defalcation
required either a knowing breach of fiduciary duty or "gross
recklessness" with regard to the conduct. The Court did not get
there by reading the dictionary. After consulting an 1867 Law Dictionary, as
well as more contemporary sources, the Court concluded that there was not a
clear answer. To illustrate the muddled state of the definition, the Court
contrasted opinions from Augustus Hand and Learned Hand reaching differing
conclusions as to whether mere negligence could constitute defalcation. In one
of my favorite passages from the opinion, the court noted that

A more modern treatise on trusts ends its discussion of
the subject with a question mark.

Slip Op. at 5. Great Scott! If treatises are using
question marks and Learned Hand disagrees with Augustus Hand, this must be a
very muddled doctrine indeed!

Instead of looking to definitions, the Court dusted
off its maxims of statutory interpretation. Using noscitur a sociis
(which means "it is known from its associates"), the Court looked at
the string of nondischargeable actions contained within section
523(a)(4): fraud in a fiduciary capacity, defalcation in a
fiduciary capacity and embezzlement. Back in 1878, the Court had concluded that
fraud, being associated with embezzlement, must mean "positive fraud . . .
involving moral turpitude or intentional wrong, as does embezzlement." This led
Justice Breyer to declaim that "the statutory term 'defalcation' should be
treated similarly." Slip Op. at 6.

Taking this analysis further, the court engaged in a
stair-stepped equivalency analysis. If the conduct "does not involve bad
faith, moral turpitude, or other immoral conduct, the term requires an
intentional wrong." Id. If conduct is not actually intentional, it must
be its equivalent.

We include as intentional not only conduct that the
fiduciary knows is improper but also reckless conduct of the kind that the
criminal law often treats as the equivalent. Thus, we include reckless
conduct of the kind set forth in the Model Penal Code. Where actual knowledge
of wrongdoing is lacking, we consider conduct as equivalent if the fiduciary
"consciously disregards" (or is willfully blind to) "a substantial and unjustifiable
risk" that his conduct will turn out to violate a fiduciary duty.

Id. In this context, I think
that the willfully blind test would be met by a trustee who responded to an
email from a Nigerian prince or who "invested" the trust funds by
depositing them in his own bank account.

Nevertheless, although defalcation thus understood was
morally similar to fraud, embezzlement and larceny, it was not identical. Embezzlement
requires conversion while larceny involves taking and carrying away someone
else's property. Fraud requires a false statement or omission. Thus,
defalcation

Slip Op. at 8. Finally, in a rather tepid endorsement of
its own position, the Court noted that it had to find that the term meant
something and that none of the parties had come up with a better idea. To show
that I am not making this up, I will quote Justice Breyer, who stated:

(I)t is important to have a uniform interpretation of
federal law, the choices are limited, and neither the parties nor the
Government has presented us with strong considerations favoring a different
interpretation. In addition to those we have already discussed, the Government
has pointed to the fact that in 1970 Congress rewrote the statute, eliminating
the word "misappropriation" and placing the term "defalcation" (previously in a
different exemption provision) alongside its present three neighbors. See Brief
for United States as Amicus Curiae 16-17. The Government believes that these
changes support reading "defalcation" without a scienter requirement. But one
might argue, with equal plausibility, that the changes reflect a decision to
make certain that courts would read in similar ways "defalcation," "fraud,"
"embezzlement," and "larceny."

Id.

Having decided what the term meant, the Court vacated the
Eleventh Circuit decision and sent it back to them to "permit the court to
determine whether further proceedings are needed and, if so, to apply the
heightened standard that we have set forth." Id.

Thus, the Court completed its term paper on the meaning
of defalcation. But what does it mean to the bankruptcy community and to the
parties in this case?

Why The Ruling Is Good

As a matter of statutory interpretation, the Court should
be commended for not simply picking a dictionary that it liked and pronouncing
that the answer was clear. Having consulted at least nine references (and two
of the Brothers Hand, both the Learned one and the one who was merely Augustus)
the Court realized that the various formulations were hopelessly inconsistent
and they said so. In my attempts to rely on the dictionary as legal authority,
I have frequently had to concede that my preferred meaning was one of several
contained within the same dictionary. The process of judging requires more than
simply opening a dictionary and pointing to a definition; it requires a thought
process. That is precisely what the court did in this case.

Next, the court required a finding of scienter. There are
five types of conduct that must be proven to be nondischargeable:
fraud under subsections (a)(2) or (a)(4), defalcation in a fiduciary capacity,
embezzlement and larceny under subsection (a)(4) and willful and malicious
injury under subsection (a)(6). Prior to this opinion, the Supreme Court
had excluded "implied fraud or fraud in law" from the definition of
nondischargeable fraud, Neal v. Clark, 95 U.S. 704 (1878), and had rejected
negligence as the basis for willful and malicious injury, Kawaahau v.
Geiger, 523 U.S. 57 (1998). With the current ruling, the Court has raised
the bar for all of the (a)(2),(4) and (6) exceptions to something much more
than negligence.

To illustrate the danger of negligence based defalcation,
consider the classic film, It's A Wonderful Life. When George Bailey sends
Uncle Billy to the bank to make the deposit (that subsequently turns up missing
causing George to contemplate suicide), there are many reasons he could be
criticized as negligent: Uncle Billy was a forgetful old man, who may
have had a drinking problem and the funds were not kept in a locked and secure
deposit bag. But was it grossly reckless, that is, to say, the equivalent of an
intentional breach of fiduciary duty? I don't think so. Had this decision come
out in 1946, George might not have jumped off the bridge (and a classic
American film might not have been made).

The opinion is also good because it distinguishes between
creditors who deserve to be protected by having to prove a lower
standard and those who should be required to establish a higher level of proof.

It is also consistent with a set of statutory exceptions
that Congress normally confines to circumstances where strong, special policy
considerations, such as the presence of fault, argue for preserving the debt,
thereby benefiting, for example, a typically more honest creditor. See, e.g.,
11 U.S.C. §§523(a)(2)(A), (a)(2)(B), (a)(6), (a)(9) (fault). See also, e.g.,
§§523(a)(1), (a)(7), (a)(14), (a)(14A) (taxes);§523(a)(8) (educational loans);
§523(a)(15) (spousal and child support). In the absence of fault, it is
difficult to find strong policy reasons favoring a broader exception here, at
least in respect to those whom a scienter requirement will most likely help,
namely nonprofessional trustees, perhaps administering small family trusts
potentially immersed in intrafamily arguments that are difficult to evaluate in
terms of comparative fault.

Slip Op. at 8. The Court demonstrates wisdom in
recognizing that family disputes can frequently turn into take no prisoners
brawls where parties make ever more outrageous accusations against each other
and hire ever more expensive lawyers to resolve conflicts that are more psychological
than financial. Even in a straight business dispute, it is not unusual for a
party to spend many times more than the amount in dispute in attorney's fees to
avenge a real or imagined wrong.

It is not hard to imagine a wrongdoer who seeks to cover
up his own large malfeasance by complaining loudly about his fellow partner's
negligible misfeasance. This is all a long-winded way of saying that requiring
proof of bad intent may be a potent antidote to allowing trial by emotion and
innuendo. While it may be a lot to ask, it is at least possible that if the
courts do not allow claims based on technical and insubstantial faults to
prevail that at least some wrongdoers in plaintiffs' clothing may lose interest
and turn elsewhere for their amusement.

Why the Ruling Is Frustrating

The Court's ruling is frustrating because it does so
little to answer the dischargeability question in specific cases or even in
this specific case. In this case, the Bankruptcy Court granted summary judgment
and was affirmed by the District Court and the Court of Appeals. The Supreme
Court reversed so that means that the Debtor wins, right? Not necessarily.
Does it mean that the Debtor gets a trial? Not even that much is certain.
Instead, the Supreme Court reversed the lower court's summary judgment with
instructions to

determine whether further proceedings are needed and, if
so, to apply the heightened standard that we have set forth.

Slip Op. at 9. What does it mean that the Court of
Appeals should "determine whether further proceedings are needed"?
I read this cryptic reference to tell the Eleventh Circuit that it
could remand the case to the Bankruptcy Court for a trial or it could solemnly
consider the Supreme Court's "heightened standard" and reach the same
result. Given that the Plaintiffs below never alleged bad intent, it seems a
given that the case should be remanded for trial or even rendered in favor of
the Debtor. However, the Supreme Court has ordered what may be a reversal in
name only.

Further, what is even more frustrating is that the Court
offers very little guidance to the Eleventh Circuit in how to apply what it
described as a "heightened" standard. In its opinion, the Eleventh
Circuit identified three levels of defalcation: the Fourth, Eighth
and Ninth Circuits allowed defalcation based upon mere negligence; the Fifth,
Sixth and Seventh Circuits required a showing of recklessness; and the First
and Second Circuits demanded extreme recklessness. The Eleventh Circuit adopted
the middle standard, that of recklessness. The Supreme Court, on the other
hand, adopted "gross recklessness" as the standard. In its opinion,
the Supreme Court hinted that it was siding with the First and Second Circuits.
The high court noted that "at least some Circuits have interpreted the
statute similarly for many years without administrative, or other practical
difficulties" and then cited to decisions from the First and Second
Circuits. Thus, "gross recklessness" and "extreme
recklessness" appear to be synonymous terms.

Rating Recklessness

So, how should courts distinguish between what is merely objectively reckless
and that which is grossly or extremely recklessness? One possibility
would be to have the guy from Fast Times At Ridgemont High listen to the
evidence. If, at the conclusion of the case, he says, "dude, that's
extreme," then the debtor loses. That's probably not what Justice Breyer
had in mind. While the distinction between objective, extreme and gross
negligence may seem like angels dancing on the head of a pin, a
comparison between the reasoning of the Eleventh Circuit and the Supreme
Court's Kawaauhua opinion may be helpful.

In the Eleventh Circuit's opinion, the fact that the Debtor knew that he was
engaged in self-dealing was enough to constitute "objective recklessness."
The Court wrote:

Applying the recklessness standard for defalcation
to the facts of the instant case, this Court concludes that the bankruptcy
court was correct in determining that Bullock committed a defalcation by making
the three loans while he was the trustee of his father's trust. Because Bullock
was the trusteeof the trust, he
certainly should have known that he was engaging in self-dealing, given that he
knowingly benefited from the loans. Thus, his conduct can be characterized as
objectively reckless, and as such, it rises to the level of a defalcation under
§ 523(a)(4). Accordingly, the bankruptcy court's order must be affirmed on the
issue of whether the Illinois judgment debt was non-dischargeable under §
523(a)(4) as a debt arising from a defalcation while Bullock was acting in a
fiduciary capacity.

670 F.3d at 1166. Thus, if the Debtor intended the
act which violated the fiduciary duty, then he was objectively reckless. However,
in Kawaauhua, the Supreme Court rejected the argument that the Debtor
need only have intended the act that caused the injury and instead held that
the Debtor must have intended the injury. While the standards of defalcation in
a fiduciary duty and willful and malicious injury are different, the common
denominator is an intent to cause the harm rather than the act that results in
the harm. This equates to the language in Justice Breyer's opinion that the
Debtor must have intended to breach a fiduciary duty or would have known he was
breaching his fiduciary duty but for his willful blindness.

To illustrate:

Under the Eleventh Circuit's approach, if the Debtor
intended to drive his car at 70 mph in a 55 mph zone, he would be objectively
reckless even if he had not seen a speed limit sign.

On the other hand, under Justice Breyer's approach, the
Debtor would be grossly reckless if he saw the 55 mph sign but did not know how
fast he was going because he had spray painted over the speedometer.

The Take Away

At a minimum, we know that defalcation precedents from
the Fourth, Fifth, Sixth, Seventh, Eighth, Ninth and Eleventh Circuits should
be re-examined in light of the Bullock case. The Debtor's best case will
be to show that he did not know that he was breaching a fiduciary duty, while
the creditor's case will be that the Debtor either actually knew he was
violating a fiduciary duty or would have known had he kept his eyes open.

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